The game between Greece and the rest of the region is clearly one of “who will blink first” because on purely rational financial economic grounds a Greek exit (Grexit) is not in the interest of any of the players in this game. Nevertheless, one has to bear in mind that non-rational elements may play a very big role in the decisions on either side as well, which basically stem from austerity and reform fatigue in Greece and funding fatigue in the rest of the region.

If Greece were to leave the euro, the consequences for the country itself would probably be devastating as funding from the EU/IMF would dry up and would certainly not be replaced by private sector capital inflows. Rather there would be substantial private capital outflows because deposits would flee the Greek banking system. In response to this, capital controls and limits on cash withdrawal would probably be instated but these are unlikely to prevent all this completely. The Greek banking system would thus come on the verge of collapse and would be in need of recapitalisation as well as access to unlimited liquidity. Recapitalisation would have to come from the Greek government so saying that its primary deficit is already close to zero because of which it no longer needs funding is a moot point. Also, the country still has a large current account deficit which is tantamount to saying that the private sector is still heavily dependent on external funding as well.

The country would thus have no choice but to reintroduce the Drachma to provide liquidity to the banking system and monetise government debt. Given the weak degree of credibility this would quickly lead to an increase in inflation (expectations) which would to a large extent erode the competitiveness gains from a devalued currency. Some commentators have talked about the possibility of introducing a currency board. While this cannot be excluded,it would mean that the "benefits" from providing liquidity to banks and financing the sovereign would not be available. All in all, there would be a substantial tightening of Greek financial conditions and credit supply which combined with steeply falling confidence would send GDP in a downward tailspin.

…and could actually be forced by the rest of the region

In all this it is important to understand that Grexit need not only come about by an “active” decision of the Greek government. The rest of the region could also push Greece out “through the back door” if Greece decides no longer to comply with the program objectives. The key issue here is the Target 2 imbalances. The ECB essentially acts as a clearing house for the national central banks. Hence, the counterpart of the current and private capital account deficits of Greece (there is substantial deposit flight!) is an increase in the Target2 liabilities of the Greek central bank (close to EUR 100 bn currently). This is essentially a capital inflow that consists of central bank money.

Last week the ECB excluded a number of smaller Greek banks from participating in its regular repo transactions because of which they are now fully dependent on Emergency Liquidity Assistance (ELA) from the Greek central bank. The collateral requirements of the latter are much looser and unlike the regular repos the credit risk remains fully with the Greek central bank. The main reason behind the ECB‟s decision is continued procrastination over the issue of Greek bank recapitalisation.

ELA is potentially a fountain of unlimited liquidity creation but the ECB can veto its use. This may very well happen if after the next Greek elections a new “anti Troika” government is put in place and Troika financing dries up. Such a new government probably wants to remain in the euro but is not willing to pay the price in terms of structural and fiscal reform. The important point here is that the government can be kept afloat for a while via the ELA financing of banks as the latter can use these funds to buy Greek government bonds. Faced with the prospect of a banking system collapse induced by an acceleration in deposit flight, the Greek central bank could thus well choose to defy an ECB veto. The latter could then respond by cutting Greece off entirely from the Target2 system. This decision will not be taken lightly and only after EU leaders approve this. If this were to happen, the “euros” created in Greece would no longer be euros!!

Outcome of Greek elections remains crucial

All will thus hinge on the outcome of the Greek elections as well as the extent to which the radical Left (Syriza) is prepared to call the bluff of the rest of the region. Recent opinion polls show some tentative signs that the “pro-Troika parties” (PASOK and New Democracy) are gaining somewhat. Perhaps, turning the election into a referendum on EMU membership will thus work. Even if Syriza wins Grexit is not 100% certain (but has a very high probability) as the extreme left may still be willing to reach some kind of compromise while the rest of the region may be willing to concede more ground as well.

The latter is, however, far more likely if the pro-Troika parties win. In that case, EU leaders may significantly slow the required pace of Greek fiscal adjustment and could even come up with some kind of Marshall plan through the use of EU's structural funds and the EIB. One cannot exclude that these “carrots” will be used before the election to increase the share of the vote for the pro-Troika parties. Here we thus have the familiar trade-off between “preventing contagion” and “preventing moral hazard” again. The Greek “example” may to some extent be used by other countries in the future to ease their burden of adjustment.
All in all, the event risk surrounding Greece thus remains extremely high. In fact, the situation could already come to a head before the election if capital flight accelerates further.

We retain our view of a 50% probability of Grexit within the next two years, because the Greek economic and social structure is too weak to bear the burden of adjustment. Nevertheless, the probability of Grexit within the next 1-2 months is somewhat lower in our view (30-40%). The main reason for this is that “we have been here before” in a sense. Every time the region seems to be heading towards the cliff there has been some kind of last minute policy innovation which prevented it from falling into the abyss. Tough talk is an essential part of any negotiation strategy but in the end policymakers have always been willing to reach a compromise so far. Having said that, the stakes are clearly higher this time around because sticking to the Troika program (at least to some extent) is very much a matter of principle.

Contagion risk for the rest of the region remains high

The consequences for the rest of the region would be a substantial amount of contagion to other peripheral sovereigns, both through treasury markets and the financial system as through the real economy as consumer and business sentiment might be impacted in other countries and social unrest might also spread. In response to this, we believe that both the ESM/IMF funds as well as the ECB would step in full force to prevent this. In the somewhat more medium-term this may even lead to an increase in the pace of necessary adjustments (move towards fiscal union including euro bonds). The tools are now in place to prevent contagion in the end and Greece is probably also already seen as substantially different from the other peripherals. Nevertheless, there would of course be an initial phase of steeply falling risk appetite before the situation stabilises.

Over the past few weeks there have already been renewed signs of contagion in sovereign and banking space. In the run up to the Greek elections one cannot exclude that other peripherals will experience deposit flight as well even though this is not yet really happening at the moment. The first line of defence against this remains the provision of unlimited ECB liquidity and the afore-mentioned possibility of Greece being cut off from Target2 certainly does not apply to other peripherals because the rest of the region sees them as substantially more compliant with their program objectives.

Nevertheless, the “passive ability” of peripheral banks to draw on ECB liquidity in the regular operations with a maturity of up to 3 months is probably not enough in the case of Grexit. If the latter happens we will see a tug of war between the ex ante capital flight and financial market pressure, on the one hand, and the speed and magnitude of the policy response, on the other. The latter will imply that the ECB will have to implement another round of LTRO‟s where collateral standards are diluted further. Also, a substantial amount of funds would be needed from the EFSF/ESM/IMF sources for bank recapitalisation and the implementation of Euro wide deposit guarantees. In this respect, ways of levering up the ESM (giving it access to ECB funding for instance) would come back on the table again, all the more so because Spain and Italy may (partially) loose market access as well.

Furthermore, a “European TARP” as well as Euro wide instead of national deposit guarantee schemes would be a very important step forward in our view. In this sense, a Greek exit may even serve as a catalyst towards further fiscal and political integration. Nevertheless, a Euro wide deposit guarantee may not be the panacea it seems at first sight. The idea is to protect depositors from a bank run which would happen if a country is planning to leave the Euro area. However, if the latter happens the guarantee would essentially be worthless. This only goes to show that in the end there is no alternative to further fiscal and economic integration including, ultimately, the introduction of Eurobonds.

For Spain in particular, we continue to believe that the root cause of the problem resides in the Spanish banking system. In this respect, the measures announced last week (additional 30 bn provisioning) are a step in the right direction but it is certainly not enough. In fact, it is very much in line with the gradualist approach taken to bank recapitalisation so far.

One wonders the Spanish government does not press ahead more forcefully, after all it can easily obtain funds from the EFSF for this purpose. Part of the reason may be because of the stigma attached to it. Also, it may be difficult to explain this politically in environment where unemployment is above 25%. Finally, there is also an element of financial repression involved. The most profitable banks in Spain have indicated that they have more or less reached the limit of the amount of Spanish bonds they want to hold. The Spanish sovereign is thus now very dependent on the smaller and weaker banks for its own funding. Recapitalising those smaller banks and making them thus far less dependent on ECB financing may also cause them to loose their appetite for Spanish government bonds.

All in all, we continue to believe that the rest of the periphery including Spain is substantially different from Greece, also because the rest of the region firmly believes they are making good faith efforts in terms of structural and fiscal reform. The heavy burden imposed on these economies may even be decreased somewhat because of the realisation that the single-minded drive towards austerity is self-defeating. In the case of an increase in contagion we believe that the policy response would eventually be strong enough to calm the situation but probably not before substantial initial damage has been inflicted on financial asset prices and the real economy.

Finally on the issue of the possibility of PSI we have not changed our view: It cannot be excluded for the smaller peripherals in the longer run (especially Portugal) but it is not our base case. The reason is that the ECB and EU leaders probably still have a trauma from the contagion effects caused by the Greek PSI so they will probably try to avoid this at all cost for now. PSI for Spain will not be necessary in our view as even in a bleak scenario its debt to GDP ratio would not peak above 100%. Also, a Spanish PSI would be a very disastrous event given its size and given the Spanish bond holding by Spanish banks.

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